Investors do not really bother with the number of stocks in their portfolio. In fact, the degree of diversification of their portfolio will directly affect the investment performance. So the question is, should an investor concentrate his capital in a few stocks or buy as many as 20 stocks?
I can tell you that there is no one clear-cut answer to the above question. The degree of diversification depends on which investment methodology an investor practices. In this article, I will only cover two investment techniques in the circle of value investing.
The Net-Net Hunters
Benjamin Graham was the pioneer of this method. Net-net is a value investing technique in which a company is valued solely on its net current assets. If the share price is two-third of the net current assets (current assets - total liabilities), the stock is considered undervalued.
They focus on quantitative analysis - the figures in financial statements. Little considerations are given to the future earnings power of a company. Hence, net-net hunters always 'talk' to the balance sheet. Future earnings is the key driver to the movement of share price, neglecting the income statement implies greater risks ahead for the investors.
For the net-net hunters, it is important to diversify and invest in more than 10 companies. Thus, the net-net hunters need to buy more shares as a means to reduce risks. In my opinion, they should own around 15 to 20 stocks in their portfolio.
Warren Buffett's Proponents
I am in this category of value investing. As a Buffett's proponent, I look out for companies with stable and increasing earnings year after year. Although the balance sheet is important, but I put more focus on identifying the company's true earnings power in the long run.
Hence, the number of stocks that I intend to own is small, possibly in the range of 5 to 8 companies. We do not treat the number of stocks in a portfolio as a means of risk reduction, but most importantly, the quality of each companies we hold plays an even bigger role in minimizing our investment's downside risk.
Thus, much time will be spent on dissecting a company's business risks. We ought to invest in companies with the slightest risks of all. So, if we own 5 companies with the slightest risks, chances are we will do well in the future. Hence, concentration is the key for this group of investors.
An investor's preference on concentration or diversification of their portfolio depends on the investment methodology. There is no one size fits all method in the stock market. So which one are you? Happy Value Investing!